In Defense of Derivatives:
They're necessities, not dangers, argues a longtime proponent

By Leo Melamed

In the last half of this century, science has moved from the
big to the little, from the vast to the infinitesimal. From general
relativity to quantum physics, from individual cells to genes.
The advances in financial markets have been strikingly similar,
but much faster. We are now in the Age of Derivatives, financial
equivalents of particle physics and molecular biology. We have
moved from long-term hedging to on-line risk management; from macro
to micro.

The new era dawned in the early 'Seventies, when the Chicago Mercantile
Exchange launched the International Monetary Market to develop
trading in financial futures. Thereafter, evolutionary forces in
finance, technology, global markets and world economies transformed
these simple tools into complex derivatives that can deal with
the fundamental components of financial risk.

Derivatives secure their values from other assets, such as stocks,
bonds, currencies or commodities. Simple futures contracts in foreign
exchange, Eurodollars and bonds have become swaps and swaptions,
strips and straps, collars and floors. Investment evolution is
the offspring of necessity.

We live in a highly hazardous economic environment, in which competition
is global, volatility is constant and opportunities rapidly appear
and disappear. Derivatives reduce risk and boost profits. They
enhance the efficiency of businesses, benefit bank depositors and
borrowers, improve portfolio managers' performance and help farmers,
mortgage lenders and commercial users of energy. Derivatives have
fostered rapid growth in international trade and capital flows,
allowing excess savings in mature industrialized countries, for
example, to be funneled into higher-yielding opportunities in developing
nations.

It should be noted that there are two types of derivatives: privately
traded over-the-counter instruments that circulate among banks
and their large corporate and institutional customers, and exchange-trading
ones financial and commodity futures and options. Combined, these
two sectors add up to a multi-trillion-dollar market.

While the OTC derivatives market is the larger, it lacks the exchanges'
protective components, such as daily mark-to-market value adjustments,
required margin deposits, price and position limits and, most notably,
the guarantee of a central clearinghouse. OTC products also lack
strict regulatory oversight.

Clearly, there
are both bulls and bears on derivatives. Many argue that derivatives
endanger the world's financial fabric. Economist Henry Kaufman,
while fully acknowledging their benefits, has warned: "The
high market volatility of our new financial world and the potential
for even higher volatility given the broad range of instruments
available to participants contain the seeds of potentially adverse
consequences for investment, for credit creation and ultimately
for monetary policy."

Unquestionably, whatever the exposure, it is off-balance sheet,
potentially volatile and difficult to assess. And the sums involved
are enormous. Regulations for strict accounting procedures and
reserve requirements are necessary.

As of year-end 1991, a Commodities Futures Trading Commission
study reports, there were 20 U.S. swap dealers with notional principal
exceeding $10 billion. And the Securities and Exchange Commission
indicates that aggregate notional principal held by major U.S.
broker - dealer affiliates on interest-rate and currency swaps
and foreign-exchange forward contracts roughly equaled the aggregate
value of these dealers' futures positions.

There are few,
if any, known loan-loss reserves within this off-balance sheet
market. Consequently, who is on the other side of the risk is
a very important question. Nevertheless, the CFTC study concluded
that "no fundamental changes in regulatory structure appear to
be needed at this time." Similarly, a recent analysis by the Group
of Thirty, a private-sector task force headed by former Fed Chairman
Paul Volcker, concluded that derivatives don't add to the risk
that already exists in today's financial environment.

That isn't to say, however, that the global financial system isn't
vulnerable to a major shock from wars, political upheaval, economic
dislocations, natural disasters, etc. Quite the contrary. At today's
market levels, such vulnerabilities are magnified.

Also, it's important to realize that the current world bull market
in financial assets is highly dependent on liquidity. Should liquidity
diminish, these assets would be significantly exposed. And derivatives
add liquidity.

Kaufman has
noted that derivatives evolved following the dramatic rise in "floating-rate
financing opportunities; massive securitization of mortgages
and other financial products; sweeping internationalization of
trading of currencies, bonds and equities; a striking shift toward
institutionalization of portfolio investment; and a worldwide
explosion of budgetary deficits, and
the associated mushrooming of so-called risk-free government bonds
. . ."

These trends aren't about to change.

Indeed, we're
poised for another quantum technological leap, via "artificial
intelligence," a phrase that embraces such trading innovations
as neural networks, fractals and chaos theory. Many major American
brokerage firms already have quietly spent hundreds of millions,
perhaps billions, to develop this technology.

The fears voiced about the risks in derivatives echo those generated
about genetic engineering. And just as Congress has found it impossible
to dully direct the development of genetic research, it will find
it is impossible to stop financial engineering. In a global market,
the ingenuity of physicists, biologists and financial market participants
will continue unabated. And so will the Age of Derivatives